Edited version of private ruling

Authorisation Number: 1011658663763

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Ruling

Subject: Capital Reduction and Cancellation of Redeemable Preference Shares (RPS)

The taxpayer is a non-resident of Australia for the purposes of Australian income tax law.

The taxpayer, the immediate holding company of an Australian resident company, is the sole shareholder of fully-paid non-cumulative Redeemable Preference Shares (RPS) in that Australian resident company.

The Australian resident company is the Australian arm of a wider global group. This global group undertook a number of strategic divestments at both an Australian and global level, which included the sale of certain arms of its business. The Australian resident company paid dividends, which represented a return of proceeds from these divestments, as well as other profits derived from its ordinary business, to the taxpayer.

The Australian resident company also disposed of its manufacturing facilities and business.

Total paid up capital of the Australian resident company has remained constant despite it having a significant decrease in its total asset base. Retained profits have also significantly decreased as a result of paying several franked dividends.

The Australian resident company now has excess levels of paid up capital due to reduced business needs, and intends to concurrently return retained profits to the taxpayer, at the same time as a capital reduction and cancellation of RPS. The amount of the capital reduction will be at the same amount at which the RPS were originally allotted.

The Australian resident company has a history of paying fully franked dividends.

Question 1

Will the Commissioner be entitled to make a determination under subsection 45A(2) of the Income Tax Assessment Act 1936 (ITAA 1936) that section 45C of the ITAA 1936 applies in relation to the whole or part of the capital reduction and cancellation of Redeemable Preference Shares (RPS) by the Australian resident company to the taxpayer?

Answer

No.

Detailed reasoning

Section 45A of the ITAA 1936 is aimed at preventing companies from streaming capital benefits and the payment of dividends to shareholders in such a way that capital benefits are provided to shareholders who would derive a greater benefit from the capital benefit than other shareholders, with it being reasonable to assume that the other shareholders have received, or will receive, dividends.

As the whole of the capital reduction proceeds will be debited against the RPS account, the taxpayer will receive a capital benefit.

As the taxpayer is the only shareholder in this case, no particular shareholder would derive a greater benefit than another shareholder.

Further, while the Australian resident company will provide its shareholders with a 'capital benefit' (as defined in paragraph 45A(3)(b) of the ITAA 1936), there is nothing in the arrangement to indicate a 'streaming' of capital benefits to some shareholders, and dividends to other shareholders. The taxpayer will receive a capital return in direct proportion to its shareholding.

Accordingly, the Commissioner will not make a determination under subsection 45A(2) of the ITAA 1936 that section 45C of the ITAA 1936 applies to the proposed capital reduction and subsequent cancellation of RPS.

Question 2

Will the Commissioner be entitled to make a determination under subsection 45B(3) of the ITAA 1936 that section 45C of the ITAA 1936 applies in relation to the whole or part of the capital reduction and cancellation of RPS by the Australian resident company?

Answer

No.

Detailed reasoning

Section 45B of the ITAA 1936 is aimed at preventing companies from providing 'capital benefits' to shareholders in substitution for the payment of dividends, and having regard to the circumstances of the scheme, it would be concluded that a person who entered into the scheme did so for a purpose (whether or not the dominant purpose, but not including an incidental purpose) of enabling a taxpayer to obtain a tax benefit. That is, the section is designed to ensure that certain payments that are paid in substitution for dividends are treated as assessable dividends for tax purposes.

When the conditions set out in subsection 45B(2) are met, the Commissioner is authorised to make a determination that any part of the capital benefit provided to the shareholder is an assessable dividend.

Scheme under which a 'capital benefit' is provided

In accordance with paragraph 45B(5)(b) of the ITAA 1936, as a reference to a person being provided with a capital benefit is a reference to the distribution to the person of share capital or share premium, the capital reduction will constitute a capital benefit. Therefore, the definition under paragraph 45B(2)(a) of the ITAA 1936 will be satisfied.

Tax benefit

A 'tax benefit' is not limited to income tax liabilities, but also includes withholding tax obligations imposed by section 128B of the ITAA 1936. Pursuant to subsection 128B(1), section 128B applies to income that is derived, on or after 1 January 1968, by a non-resident; and consists of a dividend paid by a company that is a resident. The Australian resident company would therefore have a dividend withholding tax obligation in respect of any unfranked dividends paid to the taxpayer.

The general withholding tax imposed by the ATO on dividends paid to non-residents is 30%. Pursuant to the Double Tax Agreement (DTA) between Australia and the non-resident country of which the taxpayer is a resident, the general rate of withholding tax required to be remitted on the payment of dividends is X%. Therefore, a tax benefit is likely to arise.

Therefore, in accordance with subsection 45B(9) of the ITAA 1936, the taxpayer will obtain a tax benefit due to the preservation of franking credits.

A more than incidental purpose of obtaining a tax benefit

The application of section 45B of the ITAA 1936 to the taxpayer turns on whether, having regard to the relevant circumstance of the capital reduction and cancellation of RPS, it may be concluded that it was undertaken for a purpose of enabling the taxpayer to obtain a tax benefit.

Subsection 45B(8) of the ITAA 1936 outlines the relevant circumstances of a scheme. Paragraphs (a) to (k) list the specific relevant circumstances that need to be satisfied.

(a) The extent to which the …capital benefit is attributable to capital or the extent to which the … capital benefit is attributable to profits (realised or unrealised) of the company …;

The Australian resident company returned accounting profit and retained profits from prior years to the taxpayer through the payment of fully franked dividends.

The original funding of the Australian resident company's manufacturing operations was provided through the issuance of the RPS and debt provided by a subsidiary company.

Therefore, the capital reduction and cancellation of RPS is attributable to excess working capital, which is no longer required due to the Australian resident company decreasing the size of its business operations.

(b) The pattern of distributions, bonus shares and returns of capital or share premium by the company …;

Given that a dividend will be paid simultaneously to the capital reduction to the taxpayer, in addition to the Australian resident company's history of providing franked dividends to its shareholders, the capital reduction and cancellation of RPS will not be made in substitution for dividends.

(c) Whether the relevant taxpayer has capital losses that, apart from the scheme, would be carried forward to a later year of income;

The RPS will be cancelled by an amount equal to the amount originally allotted, thereby resulting in no capital gain.

(d) Whether some or all of the ownership interests in the company … held by the relevant taxpayer were acquired, or are taken to have been acquired, by the relevant taxpayer before 20 September 1985;

The RPS are post-CGT assets.

(e) Whether the relevant taxpayer is a non-resident;

While the taxpayer is a non-resident for Australian income tax purposes, the purpose behind the proposed cancellation of RPS is not in any way influenced by the characteristics of the taxpayer.

(f) Whether the cost base … of the relevant ownership interest is not substantially less than the value of the applicable … capital benefit;

The RPS will be cancelled at the face value that they were issued.

(g) Whether the relevant taxpayer … is a private company that would not have been entitled to a rebate under section 46F if the taxpayer had been paid an equivalent dividend instead of the … capital benefit;

This paragraph has been repealed.

(h) If the scheme involves the distribution of share capital or share premium - whether the interest held by the relevant taxpayer after the distribution is the same as the interest would have been if an equivalent dividend had been paid instead of the distribution of share capital or share premium;

The interest held by the taxpayer following the cancellation of RPS will be different to that had a dividend been paid on the RPS. This supports the conclusion that the cancellation will not be made in substitution for a dividend payment.

(i) If the scheme involves the provision of ownership interests and the later disposal of those interests, or an increase in the value of ownership interests and the later disposal of those interests:

(i) the period for which the ownership interests are held by the holder of the interests; and

(ii) when the arrangement for the disposal of the ownership interests was entered into.

The capital reduction and cancellation of RPS will not involve the provision of ownership interests in the Australian resident company.

(j) For a demerger only: …

A demerger is not taking place; therefore, this paragraph is not relevant.

(k) Any matters referred to in subparagraphs 177D(b)(i) to 177D(viii) of the ITAA 1936.

Section 177D of the ITAA 1936 is part of the general anti-avoidance provisions of Part IVA. The matters referred to in subparagraphs 177D(b)(i) to (viii) are detailed and discussed below.

(i) the manner in which the scheme was entered into or carried out.

The capital reduction on the RPS to be held by the taxpayer will occur pursuant to section 256B and subsection 256C(2) of the Corporations Act 2001 (Corporations Act). The Australian resident company intends to cancel the RPS currently on issue under the general statutory power to cancel shares in paragraph 124(1)(a) of the Corporations Act.

(ii) the form and substance of the scheme.

This circumstance looks to whether the commercial reality of the scheme corresponds to its legal form. The cancellation will result in the use of excess cash reserves for the capital reduction originally invested, following the disposal of a substantial part of the business in view of existing cash reserves.

(iii) the time at which the scheme was entered into and the length of the period during which the scheme was carried out.

The capital reduction and cancellation of RPS will occur accordingly following the disposal of the Australian resident company's manufacturing operations and subsequent downsizing of its business. As a result, there are no adverse consequences surrounding the timing of any event.

(iv) the result in relation to the operation of this Act that, but for this Part, would be achieved by the scheme.

This factor refers to the result that would have been achieved by the scheme if section 45B of the ITAA 1936 did not apply. The income tax implications of a cancellation of RPS would be the receipt by the taxpayer of the face value of the RPS, with no capital gain. There should be no direct tax consequences for the taxpayer on the basis that the capital reduction and cancellation of RPS is a payment of a capital nature to a non-resident and not a frankable or unfrankable distribution.

(v) any change in the financial position of the relevant taxpayer that has resulted, will result, or may reasonably be expected to result, from the scheme.

A capital reduction and cancellation of RPS would effect the financial positions of the taxpayer and the Australian resident company. However, changes would be limited to those which would be expected to occur under such circumstances.

(vi) any change in the financial position of any person who has, or has had, any connection (whether of a business, family, or other nature) with the relevant taxpayer, being a change that has resulted, will result or may reasonably be expected to result, from the scheme.

A capital reduction and cancellation of RPS would effect the financial positions of the taxpayer and the Australian resident company. However, changes would be limited to those which would be expected to occur under such circumstances.

(vii) any other consequence for the relevant taxpayer, or for any person referred to in subparagraph (vi), of the scheme having been entered into or carried out.

As the taxpayer is the sole shareholder of the Australian resident company, a capital reduction and cancellation of RPS would not affect any other shareholder's shareholding in the Australian resident company, as there is no other shareholder.

(viii) the nature of any connection (whether of a business, family or other nature) between the relevant taxpayer and any person referred to in (vi) above.

The taxpayer is the sole shareholder of the Australian resident company.

The factors considered under subsection 45B(8) of the ITAA 1936 support the conclusion that the proposed capital reduction and cancellation of RPS should not be considered to be undertaken for the main or substantial purpose of enabling any party to obtain a tax benefit. Accordingly, the Commissioner will not apply section 45B of the ITAA 1936 in relation to the capital reduction and cancellation of RPS.

Question 3

Will any part of the capital reduction to the taxpayer by the Australian resident company and cancellation of RPS by the Australian resident company be a dividend as defined in section 995-1 of the Income Tax Assessment Act 1997 (ITAA 1997) for income tax purposes, and therefore, be excluded from the assessable income of the taxpayer pursuant to subsection 44(1) of the ITAA 1936?

Answer

No. As no part of the capital reduction and cancellation of RPS will be considered to be a dividend as defined in section 995-1 of the ITAA 1997 for income tax purposes, subsection 44(1) of the ITAA 1936 will not require consideration.

Detailed reasoning

Subsection 44(1) of the ITAA 1936 includes in a shareholder's assessable income a dividend, as defined by subsection 6(1) of the ITAA 1936, which is paid to the shareholder out of company profits.

Ordinarily, pursuant to paragraphs 6(1)(a) and (b) of the ITAA 1936, the capital reduction and cancellation of RPS would constitute a distribution by the Australian resident company to the taxpayer, and would therefore be a dividend for tax purposes.

However, while paragraphs 6(1)(a) and (b) of the ITAA 1936 will be satisfied, consideration needs to be given to the exclusions to paragraphs 6(1)(a) and (b), contained in paragraphs 6(1)(d), (e) and (f) of the ITAA 1936. In consideration of the exclusions:

§ paragraph 6(1)(d) of the ITAA 1936 will not be applicable, as it does not relate to the cancellation of RPS. Accordingly, subsection 6(4) of the ITAA 1936 will not be applicable;

§ paragraph 6(1)(e) of the ITAA 1936 will apply;

§ paragraph 6(1)(f) of the ITAA 1936 has no relevance.

The exclusion to paragraphs 6(1)(a) and (b) of the ITAA 1936 contained in paragraph 6(1)(e) of the ITAA 1936 will apply where the Australian resident company complies with the following requirements in relation to the capital reduction and cancellation of RPS:

1. The Australian resident company gives the taxpayer a notice when it cancels the RPS;

2. The notice specifies the amount paid-up on the share immediately before the cancellation;

3. The amount is debited to the Australian resident company's share capital account; and

4. The amount specified in the notice does not exceed the amount paid-up on the RPS.

Items (1), (2) and (4) will be satisfied, as the Australian resident company will provide a notice to the taxpayer when it cancels the RPS. Item (3) will also be satisfied, as the whole of the capital return amount will be debited against its share capital account.

Due to the applicability of paragraph 6(1)(e) of the ITAA 1936, no part of the capital reduction to the taxpayer and cancellation of RPS by the Australian resident company will be a dividend as defined in section 995-1 of the ITAA 1997 for income tax purposes.

Accordingly, it will not be necessary to consider whether a dividend, as defined in section 995-1 of the ITAA 1997 for income tax purposes, will be excluded from the assessable income of the taxpayer pursuant to subsection 44(1) of the ITAA 1936.

Question 4

Will CGT Event C2 occur, pursuant to subsection 104-25(1) of the ITAA 1997, upon the taxpayer having its RPS cancelled and receiving a capital amount in respect of shares it ceases to own at the time the shares are cancelled?

Answer

Yes. However, there will be no capital gain unless the capital amount received by the taxpayer exceeds the amount calculated under the indexation provisions, if indexation provisions are applied to the cost base.

Detailed reasoning

The right of the shareholder of the Australian resident company, the taxpayer, to receive payment will be discharged or satisfied when payment is made on the capital reduction, causing CGT event C2 in section 104-25 of the ITAA 1997 to happen. Therefore, only paragraph 104-25(1)(a) of the ITAA 1997 will require consideration for the purposes of CGT event C2, as there will be a capital reduction equal to the face value of the RPS, and a cancellation of RPS.

In working out the capital gain or capital loss made from CGT event C2, the capital proceeds will be the amount of the capital reduction.

The cost base of the taxpayer's right to receive a payment on the capital reduction is worked out in accordance with Division 110 of the ITAA 1997.

CGT event C2 will occur. However, as the capital proceeds will not exceed the cost base, there will be no capital gain.

Further, due to the fact that CGT event C2 will occur, and the RPS were originally acquired prior to 11.45am on 21 September 1999, the indexation provisions as permitted under section 110-36 of the ITAA 1997 may apply to the cost base, where the appropriate choice is made.

The operative indexation provision is contained in Division 114 of the ITAA 1997. In accordance with Division 114, if indexation was applied, a capital gain would not occur unless the amount of the capital proceeds exceeds the amount calculated under the indexation provisions.

Question 5

Where there is a capital gain in accordance with CGT Event C2, pursuant to subsection 104-25(1) of the ITAA 1997, would the taxpayer be taxable on any gain made from the cancellation of RPS on the basis that the RPS constitutes taxable Australian property in accordance with Division 855 of the ITAA 1997?

Answer

No.

Detailed reasoning

As a foreign resident shareholder, the taxpayer will make a capital gain from the proposed capital reduction only if its shares in the Australian resident company are 'taxable Australian property', pursuant to section 855-10 of the ITAA 1997. The term 'taxable Australian property' includes direct or indirect interests in Australian real property and the business assets of an Australian permanent establishment (section 855-15 of the ITAA 1997).

Where a capital gain arises pursuant to CGT event C2, on the basis that the only Australian real property that the taxpayer could be deemed to hold is through its 100% owned subsidiary, the Australian resident company, only an indirect Australian real property interest pursuant to section 855-25 of the ITAA 1997 may arise in accordance with section 855-15 of the ITAA 1997.

The taxpayer will satisfy the non-portfolio interest test under paragraph 855-25(1)(a) of the ITAA 1997, on the basis that it currently holds a 100% interest in the Australian resident company, and has held this interest for a period of greater than 24 months. However, paragraph 855-25(1)(b) of the ITAA 1997 requires the principal asset test, pursuant to section 855-30 of the ITAA 1997, to be passed.

The 'principal asset' test will not be met, as 50% of the market value of the Australian resident company's assets are not attributable to Australian real property under section 855-30 of the ITAA 1997.

A foreign resident shareholder who has a right to the payment of the proposed capital reduction, disregards any capital gain or capital loss made when CGT event C2 happens to that right because the right is not 'taxable Australian property', pursuant to section 855-10 of the ITAA 1997.